If you have attended a board meeting where a director recuses himself from a contract discussion or seen a promoter abstain from voting on a routine resolution, you have encountered the law on related parties. This area of company law often remains unnoticed until it becomes critical to the outcome of a transaction when issues arise.
The Companies Act 2013 strengthened the regulation of related party transactions compared to the 1956 Act. Along with SEBI’s Listing Regulations and relevant accounting standards, the law now broadly covers anyone who may influence company decisions. For directors, company secretaries, auditors and compliance officers, adherence is vital.
Why the law cares about related parties
The principal objective underlying the regulation of related party transactions is to prevent the company from being disadvantaged by transactions involving parties with a personal interest. For instance, a director may cause the company to enter into contracts with a relative’s firm on terms that are not commercially justified or a parent company may transfer funds to a subsidiary in a manner that benefits controlling shareholders to the detriment of minority shareholders. Although such transactions may appear inconsequential in isolation, their cumulative effect can result in significant erosion of shareholder value.
The legislative framework adopts a twofold approach: firstly, by providing an expansive definition of ‘related party’; and secondly, by mandating requisite approvals, disclosures and adherence to arm’s length principles in respect of transactions involving such parties.
Who is a related party: Section 2(76)
Section 2(76) of the Companies Act 2013, read with Rule 3 of the Companies (Specification of Definitions Details) Rules 2014, contains the definition. It lists the following as related parties of a company:
- A director or his relative.
2. A key managerial personnel or his relative. KMP here means the managing director, the CEO, the manager, the whole time director, the company secretary, the CFO and any other officer who is prescribed as such.
3. A firm in which a director, manager or his relative is a partner.
4. A private company in which a director or manager or his relative is a member or a director.
5. A public company in which a director or manager is a director and holds, along with his relatives, more than two per cent of its paid up share capital.
6. Any body corporate whose board of directors, managing director or manager is accustomed to act on the advice, directions or instructions of a director or manager of the company.
7. Any person on whose advice, directions or instructions a director or manager of the company is accustomed to act. This clause and the one above come with an important carve out. If the advice is given in a purely professional capacity, such as by a lawyer, auditor or consultant, it does not make that person a related party.
8. Any body corporate which is a holding, subsidiary or associate company of the company, a subsidiary of a holding company to which it is also a subsidiary (a fellow subsidiary), or an investing company or the venturer of the company. An investing company here means a body corporate whose investment in the company makes the company its associate.
9. A director, other than an independent director, or a key managerial personnel of the holding company, or his relative. This last category comes in through Rule 3, which the government notified separately.
For Section 188, the provision regarding holding, subsidiary and associate companies does not apply to private companies. This exemption aims to reduce compliance burdens for closely held private groups.
What does “relative” mean
A relative is defined under Section 2(77) of the Act, read with Rule 4 of the same Rules. A person is a relative of another if they are members of the same Hindu Undivided Family, or if they are husband and wife, or if they fall within a specific list. The list covers father (including step father), mother (including step mother), son (including step son), son’s wife, daughter, daughter’s husband, brother (including step brother) and sister (including step sister).
This definition is narrower than the common understanding of family. For example, cousins, uncles, and aunts are not considered relatives under the Act.
What is a related party transaction: Section 188
Once you know who the related parties are, Section 188 tells you which transactions with them need approval. The section covers seven categories of contracts or arrangements:
- Sale, purchase or supply of any goods or materials.
2. Selling, disposing or buying property of any kind.
3. Leasing of property of any kind.
4. Availing or rendering of any services.
5. Appointment of any agent for the purchase or sale of goods, materials, services or property.
6. Such related party’s appointment to any office or place of profit in the company, its subsidiary or associate company.
7. Underwriting the subscription of any securities or derivatives of the company.
For these transactions, the company must obtain board consent through a resolution passed at a board meeting. A resolution by circulation is insufficient.
When do shareholders have to approve
Board approval is the initial requirement. Shareholder approval is also needed when a transaction exceeds the thresholds specified in Rule 15 of the Companies (Meetings of Board and its Powers) Rules 2014. In summary, an ordinary resolution by shareholders is required when:
- Sale, purchase or supply of goods or materials, directly or through appointment of an agent, exceeds ten per cent of the turnover of the company or Rs. 100 crore, whichever is lower.
2. Sale, purchase or disposal of property, directly or through an agent, exceeds ten per cent of net worth or Rs. 100 crore, whichever is lower.
3. Leasing of property exceeds ten per cent of turnover or Rs. 100 crore, whichever is lower.
4. Availing or rendering of services, directly or through an agent, exceeds ten per cent of turnover or Rs. 50 crore, whichever is lower.
5. Appointment to an office or place of profit attracts a monthly remuneration of more than Rs. 2.5 lakh.
6. Underwriting remuneration exceeds one per cent of net worth.
Turnover and net worth are determined from the previous financial year’s audited statements. The thresholds apply to transactions individually or in aggregate during the financial year.
A related party who is also a member of the company cannot vote on a resolution approving a transaction in which he is interested. This restriction does not apply to private companies or to companies where ninety percent or more of the members, by number, are relatives of promoters or related parties.
The ordinary course of business and arm’s length exception
Section 188 carries an important exception. It does not apply to transactions entered into by the company in the ordinary course of business, provided they are on an arm’s length basis. Arm’s length here means a transaction between related parties structured as though they were unrelated with no conflict of interest colouring the terms.
The Act does not define ‘ordinary course of business’. This determination is typically based on the memorandum’s objects clause, the nature of the business, past practices and industry norms. The company must demonstrate that a transaction is both in the ordinary course and at arm’s length. Proper documentation of pricing, comparable quotes and commercial terms supports this requirement.
Transactions between a holding company and its wholly owned subsidiary are also exempt from the shareholder approval requirement, provided the subsidiary’s accounts are consolidated with the holding company and presented to the general meeting.
Disclosures in the board’s report
Under Section 188(2), every contract or arrangement entered into with a related party under Section 188(1) has to be referred to in the board’s report to the shareholders, along with the justification for entering into it. This is in addition to the disclosure required under the applicable accounting standards (AS 18 or Ind AS 24) in the notes to accounts.
For transactions above a notified value, the prescribed form is AOC-2, which is annexed to the board’s report.
Consequences of non compliance
If a contract is entered into by a director or employee without the required board or shareholder approval, and is not ratified by the board or the shareholders within three months, the contract becomes voidable at the option of the board. If the transaction is with a related party of any director, or is authorised by a director, that director must indemnify the company against any loss.
After the Companies (Amendment) Act 2020, which came into force on 21 December 2020, the old punishment of imprisonment and fine has been replaced by a civil penalty. Any director or employee who enters into or authorises a contract in breach of Section 188 is liable to a penalty of Rs. 25 lakh in the case of a listed company and Rs. 5 lakh in any other company.
A quick word on listed companies
Listed companies have to deal with an additional layer under Regulation 23 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015. The LODR definition of related party is wider and includes, among others, any person or entity holding ten percent or more of the equity shares of the listed entity. Material related party transactions under LODR require prior approval of shareholders by ordinary resolution and prior approval of the audit committee is mandatory for all related party transactions of the listed entity and its subsidiaries. Listed entities also report their related party transactions to the stock exchanges every six months.